The recent U.S. market rally, combined with what could be a disappointing second-quarter earnings season, has set the stage for a dangerously volatile few months ahead for investors.
Corporate America is in the midst of a profit recession, with earnings declining for six consecutive quarters. S&P 500 companies are expected to post a decline in earnings for the second quarter of 5.6 per cent from the prior year, according to FactSet estimates as of last week. That would make it seven straight quarters.
The problem, and the potential source of volatility, is that the S&P 500's recent 7.5-per-cent rally since June 27 strongly suggests that investors either aren't positioned for another earnings decline – or are optimistically betting that the profit outlook will improve. The benchmark is hitting new all-time highs while the earnings growth outlook remains – to put it charitably – mediocre.
Analysts are often (and reasonably) derided for being too optimistic about the earnings outlook for their companies. But even they remain skeptical about future profit growth.
"Bottom-up consensus estimates suggest that S&P 500 adjusted earnings per share will fall by 3 per cent year over year in the second quarter," said David Kostin, chief U.S. equity strategist at Goldman Sachs. "We expect that growth using operating EPS … will also be negative, marking the seventh consecutive quarter with negative EPS growth. This has never happened outside of an economic recession."
The second-quarter earnings season kicked off Monday evening with Alcoa reporting its latest numbers.
The accompanying chart compares the year-over-year returns for the S&P 500 with the year-over-year change in analyst earnings estimates for the next 12 months.
The chart shows that the profit outlook for the S&P 500 has been declining for quite some time. Estimates declined from 8.5 per cent growth in September, 2014, to a 2.5 per cent decline by October, 2015. The year-over-year returns for the index deteriorated sharply afterward. There's been marginal improvement in the profit outlook since then, but earnings per share estimates for the benchmark remain at an anemic 0.2 per cent relative to 12 months ago.
The investor cliché that "markets always look forward" is frequently helpful and it's rarely a good idea to think that market prices – as the consensus view of all investors involved – are wrong. It's certainly possible that the analysts' outlook is wrong again, only this time they are too pessimistic, not optimistic.
Markets are poised for a big move as second quarter earnings are released. The dilemma for investors is to figure out which way.
If Mr. Kostin is right and results are disappointing, the best investors can hope for is that the recent rally – all 150 points on the S&P 500 – will be reversed. How bad things get will depend on the aggregate forward looking growth estimates voiced by corporate management. The happier scenario, that the market optimism is justified, would see stock prices ramp quickly higher as profit estimates are revised upward.
Either way, I would be surprised if the U.S. equity market doesn't move higher or lower by at least 5 per cent as earnings results are released. Investors should brace themselves for volatility.
Follow Scott Barlow on Twitter @SBarlow_ROB.